What is disability insurance?
While our homes may be the greatest financial asset on our balance sheet, until we become financially independent, our ability to produce an income is a much greater financial asset. Once we have enough asset-producing income, our ability to produce earned income becomes less important. Until you become financially independent and do not need to work to produce an income, your ability to get up every morning and go to work is extremely valuable and needs to be protected. Disability insurance provides this protection.
Disability insurance could be called income protection insurance—it replaces part of your income if you become seriously ill or injured and cannot work. While the basic concept behind disability insurance is really pretty simple, there are a lot of “moving parts” that can make analyzing and comparing a disability policy difficult.
- How much will the policy pay? Insurance is supposed to make you whole, but when it comes to disability insurance, these policies fall short. Insurance companies do not want to encourage policyholders to fake a disability or to remain disabled, so they will never pay 100% of your pre-disability income. Most policies pay anywhere between 60% and 80% of your base salary. For example, if you earn a $60,000 salary, a common disability policy will pay $36,000 per year (60% of $60,000). Not all policies pay the same percentage, so it is important get all the facts on a policy when comparing premiums.
- What is the maximum a policy will pay per month? Although a policy will replace a certain percentage of income—say 60%—all policies have a maximum monthly payout. The maximum monthly payout varies by insurance company, but generally it is between $5,000 and $10,000. For example, if you earn $225,000 a year and you have a policy that covers 60% of your salary with a maximum monthly cap of $6,000, the policy would only pay $72,000 a year ($6,000 cap times 12 months) and not $135,000 (60% of $225,000).
- How long will the policy pay? Policies can pay out for as short a time as a year or until age 65. Because disability insurance is intended to replace earned income, policies stop paying when a policyholder reaches retirement age.
- What is the definition of “disability”? A disability is a physical or mental condition that limits your ability to work as a result of sickness or injury. Each policy has its own definition of disability:
Any occupation – The inability to perform the duties of any occupation. This definition is also known as the Burger King disability policy because even if you’re only capable of flipping burgers this policy won’t pay out.
Modified own occupation – The inability to perform duties or your occupation, or any occupation for which you are deemed reasonably qualified by education, training, or experience. This is a common definition of disability on many policies issued today.
Own occupation – The inability to perform the material and substantial duties of your regular occupation. This is the best definition of disability you can have but is more expensive and fewer insurance companies offer this kind of protection.
- How quickly will benefits start? This is another option that you are able to modify when creating your income protection plan. You can choose a waiting period of as little as 30 days or you can extend it to 60, 90, or more days. Think of this feature as a deductible. The longer you extend the waiting period, the larger the “deductible” and the more expense for which you assume responsibility.
- Will the policy payout increase with inflation? Again, this is another “moving part” where you have some control in designing a disability policy. A policy with inflation protection will cost more than one that does not increase with inflation.
- Does the policy offer income protection if I return to work but make less? This feature is typically called residual disability and it will pay a benefit to a policyholder who returns to work and makes less money.
- Will benefits be reduced if I received benefits from other sources? Some policies will pay out a monthly benefit but will reduce it dollar for dollar from any other benefit sources (e.g., Social Security, other disability policies). This kind of policy is inferior to one that will pay out regardless of other benefits sources.
- Can the insurance company cancel my policy or increase my rates? If you have a guaranteed renewable policy, they cannot cancel your policy if you pay the premiums. The insurance company can increase your premiums if they also increase other policyholder’s premiums. In other words, the insurance company can’t single you out and increase your rates, but it can increase them for a whole class of policyholders. A guaranteed renewable policy is good, but a noncancelable policy is better because the insurance company can’t ever cancel your policy or increase your premiums if you pay your premiums.
Disability insurance is offered through two sources. The most common source of disability insurance is through a group plan provided by an employer. The second source of disability insurance is from private insurance contracts. Both sources have disadvantages and advantages, and for many people, a combination of the two is best.
Group Disability Insurance
A lot of companies offer disability insurance to their employees as part of their employee benefits plans. The good news is that most of the time these plans are automatically provided without any cost to the employee. However, while these group plans offer a great place to start your income protection plan, most of them have serious limitations:
- Low payout percentage of income. The maximum percentage of income the standard group plan will pay is 60% of an employee’s base salary. For example, if you earn $100,000 a year, the group plan will only pay $60,000.
Problem – Individuals used to receiving a certain salary may find that their disability income benefits that pay 60% do not cover their expenses, especially at a time when there are added costs to treat the disability.
- Payout percentage restricted to salary only. Most group disability plans calculate an employee’s income on their base salary only and do not include commissions or bonuses.
Problem – Executives and salespeople who earn a relatively small base salary supplemented by significant bonuses or commissions may find their group disability insurance policy nearly worthless.
- Low maximum payout caps. Almost all policies have a maximum monthly cap they pay policyholders. This maximum payout is usually $5,000 to $6,000 per month, even if this amount is much less than 60% of the employee’s base income.
Problem – High income earners expecting to fully replace their income if they become disabled may be caught off guard when they learn of the maximum payout caps on their group policies.
- Benefits are taxable. If your employer pays the premiums for your disability insurance, you will be taxed on any payout.
Problem – Federal and state tax rates can further erode an employee’s income protection plan.
- Weak definition of disability. Rarely do group plans provide for an “own occupation” definition of disability. Good group plans will have a “modified own occupation” definition, but even these are becoming more difficult to find.
Problem – Unless the plan has an “own occupation” or “modified own occupation” definition of disability, if you can perform the tasks of any position you are no longer considered disabled and will not receive income from the disability plan.
Because of the limitations of group disability plans offered by employers, nearly everyone should at least consider supplementing their group disability plan with an individual disability insurance plan.
Individual Disability Insurance Plans
Individual disability plans are often more generous and flexible than group disability plans. Individual plans can be used to fill in the gaps of a group plan or can be the primary source of income protection because of their numerous advantages.
- Higher payout percentage of income. While group plans typically limit their maximum percentage payout at 60%, individual plans can be purchased that will pay out 70%, 80%, or more of an individual’s pre-disability income.
- Payout includes bonuses and commissions. Not all individual plans include bonuses and commissions, but there are some that do. Try to find one with this feature if this is a big part of your annual compensation.
- Payout is not taxable. The disability income paid to a policyholder is not taxable if the premiums for the individual disability plan are paid by the policyholder.
- The “own occupation” definition is available. Own occupation coverage is provided by some insurance companies.
- Higher maximum payout caps. Maximum monthly payout caps can be as high as $50,000 or over $100,000.
Of course, all of these benefits and this flexibility come at a cost. Unlike group plans, individual disability plans are paid by individuals and almost always require a medical exam. Even with these limitations, individual plans can be a critical part of your income protection plan.
Do you need disability insurance?
The statistics on disability are shocking. You are three times more likely to need disability insurance by the time you are 65 than you are life insurance. According to a Hartford study, one-third of Americans will find themselves disabled for at least 90 days during their working years.
A long-term disability can destroy a family’s finances very quickly. What would happen if you couldn’t work for six months? Nine months? Two years? Would your company continue to pay you? Can you count on it? If not, how will you pay your bills? Will you have to sell your investment accounts? Will you have to sell your home?
Your ability to generate an income is your greatest asset and its significance cannot be underemphasized. Unless you are financially independent, the money you generate not only pays your expenses but also funds your retirement. If you want to accomplish 100% of your goals, the ability to generate sufficient assets is crucial.
Even with the compelling statistics on disability, most people don’t think they need disability insurance. Disability, it seems, is something that happens to anybody but them. We all suffer from Superman Syndrome; we think we are invincible. When I sense this, I remind uninsured and skeptical clients that the Man of Steel, Superman himself—Christopher Reeve—became disabled. There is a greater frequency of disability in higher-risk occupations—such as Super Hero, but anybody in any occupation can suffer a disability.
Unlike death, disability has two unique problems. Not only are you not earning an income or saving for retirement, you still have a mortgage, utilities, clothing, and food costs and additional expenses as a result of your disability such as transportation, medication, therapy, etc. It is a double whammy—no income and more expenses—that can quickly decimate a family’s finances. If your goal is to insure your family’s future, an appropriate amount and type of disability insurance is absolutely critical.
Reasons why you wouldn’t need disability insurance
There are no precise formulas that can determine when disability insurance isn’t necessary, but there are several situations where there may be little need. Consult an independent financial advisor who does not earn a commission on insurance if you are not sure if a disability policy is right for your situation.
- Retired. Disability insurance is to replace earned income during working years. If you are retired, you don’t have any earned income to replace.
- Almost retired. If you are near retirement and have the resources to cover a year or two of living expenses, you might not need a disability policy. You can invest the premiums you save on a disability policy in your retirement.
- Financially independent. Regardless of your age, if you don’t require earned income to support your lifestyle, you may not need a disability policy. However, if you have passive income that requires your participation, you might consider a disability policy to hire a part-time employee to take over your involvement. For example, if you have rental real estate that you actively manage, consider an individual disability policy that would provide an income for you to pay someone to manage your properties while you are disabled.
- No income. If you don’t currently have an income or expect to have one in the immediate future, a disability policy will not be helpful since a policy will only pay a percentage of your current salary.
When an individual disability plan is necessary
Unless you fall within one of the categories listed above, you need an income protection plan. For many people, this need begins and ends with a group disability plan. For others without group disability coverage or for those who need additional protection, an individual plan may be necessary.
- No group disability coverage. If you don’t currently have any source of income protection if you become disabled, you need an individual disability insurance policy.
- Maximum percentage of income not enough. If your expenses are greater than 60% of your income (remember that you will pay tax on the 60% payout from your group disability policy), you will need an individual policy to increase the percentage to 70% or 80%.
- Earn $120,000 or more a year. Since most group plans pay out 60% of income or a maximum of $6,000 a month, if you earn $120,000 or more your group plan will be capped out at the maximum benefit of $6,000 a month. If your fixed expenses are more than $4,000 or so a month (this is approximately what you’d take home after taxes), an individual disability policy that increases the non-taxable income payout percentage to 70% or 80% with higher monthly caps may be necessary.
- Small salary with large bonuses/commissions. Most group plans do not consider bonuses and commissions when calculating benefits. You should look for an individual policy that specifically includes these sources of income.
- Highly specialized occupation or business owner. If your compensation is based on performing highly specialized work such as a surgeon or attorney, or if you own a business, an individual disability policy with “own occupation” is critical. With just a group plan, your new career may be the fry guy at your local McDonalds.
How much disability insurance do I need?
The short answer is—as much as you can get. For most people, an income protection plan revolves around disability insurance—this is the only way to “insure your future” if you become disabled.
Calculating how much disability insurance you need is straightforward. You will need as much disability insurance protection as you have expenses that you are responsible for paying. If you become disabled, chances are that most of these expenses will not change—they are fixed. A few expenses will decrease or be eliminated such as gasoline, dining out, business lunches, expensive business clothes, certain hobby expenses, and disability insurance premiums (once you become disabled, you won’t have to pay the premiums if you get the right rider), there will be new expenses such as transportation, healthcare, medication, and special nursing or therapy. Just like retirement, don’t assume that if you become disabled your expenses will decrease. Chances are they will stay the same or even increase.
Minimum Amount of Disability Insurance Calculation
Step 1. Enter total monthly expenses for your family. $__________
Step 2. Enter total income your spouse or partner generates $__________ (if single, enter $0)
Step 3. Enter total income from other sources (e.g., group disability, investment, rental real estate) $__________
Step 4. Add Step 2 + Step 3 to get total additional monthly income $__________
Step 4. Subtract Step 4 from Step 1 $__________
This is the minimum amount of disability insurance you need to cover your or your family’s expenses. Now perform the same calculation for your spouse or partner to determine how much insurance she needs.
In a perfect world…
… You could afford as much disability insurance as you need, but most of us have other expenses—retirement savings, college education, braces, mortgages, alimony—vying for your paycheck. The formula above calculates the minimum amount of disability insurance you need to cover your expenses. If you can afford additional insurance, it may make sense to increase the monthly benefit amount to a level that will allow you to save and invest.
The proceeding blog post is an excerpt from The Six-Day Financial Makeover: Transform Your Financial Life in Less Than a Week!, available now on Amazon.
About the Independent Financial Advisor
Robert Pagliarini, PhD, CFP®, EA has helped clients across the United States manage, grow, and preserve their wealth for the past 25 years. His goal is to provide comprehensive financial, investment, and tax advice in a way that was honest and ethical. In addition, he is a CFP® Board Ambassador, one of only 50 in the country, and a real fiduciary. In his spare time, he writes personal finance books, finance articles for Forbes and develops email and video financial courses to help educate others. With decades of experience as a financial advisor, the media often calls on him for his expertise. Contact Robert today to learn more about his financial planning services.